Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) is $1 million, and it pays taxes at a 40 percent rate. It has $5 million in assets and, because it is all-equity financed, $5 million in equity. Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interest rate of 8 percent.

Assume that EBIT could be as low as $500,000 (with a probability of 20 percent) or as high as $1.5 million (with a probability of 20 percent). There remains a 60 percent chance that EBIT would be $1 million. Complete an analysis for each level of EBIT, and find the expected values for the firm’s net income, total dollar return to investors, and ROE. What lesson about capital structure and risk does this illustration provide?

Original:

$400,000 in tax

$600,000 net income

ROE=12%